Servicing a business is like servicing equipment!

When servicing equipment a mechanic follows a series of steps. There are things to be checked, parts to be replaced, measurements (timing?) to be taken. There are tools, equipment and manuals to help him do the job. And when everything is taken apart and serviced everything must be put back together, in the right place and in the right order.

If the mechanic does not do this then the equipment will not run as well as it should. It may not even run at all. To achieve all this the mechanic follows a series of procedures, a system which backs up his training. No doubt there is a manual for the model which provides guidance and a point of reference. Even with the manual it is unlikely that the mechanic could service the truck properly if he didn't have the right training.

Is the business machine any different? Are there business "systems" to be monitored regularly, oil water and fuel consumption check and parts updated? Does the business have a set of gauges which can be checked, or a ‘dashboard' to tell the mechanic how it is performing?

There are symptoms of the underlying problems causing Ace Mechanical Services to perform poorly (yes, it is performing poorly!), but there is also at least one major underlying problem. And underneath that there is a more fundamental problem.

The Symptoms

A cry for help

Despite increasing Sales Ace Mechanical Services is suffering severe cash flow problems and the workload this and other factors is imposing on Mrs Smith, who provides the administrative support for the company, is causing noticeable stress.

The apparent symptoms of problems in the business are extreme pressure on the availability of management time to administer the business, and cash flow pressures to juggle finance and creditors to keep the business ticking along.

Available Management Time

There are two issues to be addressed in dealing with the management stress observed. The first is dealing with time, effort and stress required to deal with the cash flow difficulties the company continually faces. Relieving these will go a long way to removing the stress element. They also take time to deal with. Removing the problem will free up time.

The second issue is the administration and systems required to support a turnover of over $1 million and 10-12 staff.

Many administrative tasks are repetitive and involve data input etc. If possible this should be undertaken at a clerical level, freeing up time for management decisions. Steps have been taken to solve this problem. However the business needs to systematise the repetitive tasks where ever possible.

Lack of, inaccurate or untimely data into the business system may be causing many of the problems.

Obviously dealing with debtors and creditors when they are a problem takes time and causes many interruptions to whatever task is being worked on at the time. However there may be other underlying issues behind the time being taken. Take the payroll.

The payroll has been taking 9 hours to prepare but was recently done in 3.5 hours, an improvement which appears to be sustainable. Improvement is possible! But why has it been taking so long normally? Employees fill out an Attendance Sheet, from which they are paid, and a Job Card, from which the company is paid (via Invoices raised from it.) Reportedly the Attendance Sheet hours are likely to be accurate but the Job Sheet hours may not be accurate, or even necessarily recorded. Reconciling the two takes time and effort.

Accurate Job Cards would

Reduce the time taken to prepare the payroll,

Reduce the time to prepare Invoices; and

Result in more accurate, and therefore more profitable, invoices.

Suppliers - Ace Mechanical Services has 50 - 60 suppliers. That seems a lot. The more suppliers the greater the administrative burden. There are efficiency gains to be made by reducing the number of suppliers.

Cash Flow Problems?

Evidence of the cash flow problems can be seen in the accounts (with the proviso that our analysis is based upon the last full year's financial statements available). Analysis shows:

2003

2004

2005

SHORT TERM RISK

Current Ratio

1.37

1.12

0.93

Liquid Ratio

1.32

1.06

0.88

EFFICIENCY

Collection Period (days)

106.92

92.07

75.63

Payment Period (days)

111.07

203.65

133.28

Short term risk is measured through the exposure of the company to requirements which must be met in the short term (i.e. less than 12 months). Current and Liquid Ratios are the most significant of these measures. The Current Ratio compares the Current Assets available to pay Current Liabilities, with a ‘rule of thumb' of 2 (giving a safety margin). Over the last three years both ratios have been declining, to the point where there was negative Working Capital in 2004-05. Ace Mechanical Services had only 93 cents available to pay every dollar of creditors.

Discussions confirm cash has been tight. This is also seen in the Collection and Payment period - the average number of days taken for debtors and creditors to be paid. Ace Mechanical Services is not very efficient in collecting debts. Although this is improving 75 days is well outside what would be considered acceptable in most companies. The cost in working capital is significant. A reduction to a more normal 42 days would free up $101,619 in available funds. Would that have made a difference?

However it is of concern that creditors are paid much more slowly. In 2005 it took nearly twice as long to pay creditors as to collect debts (76 days to 133 days). This could leave the company vulnerable to action by creditors, although the position is alleviated by the fact that creditors are much less than debtors. Had Creditors been averaging 42 days they would have stood at $45,060 at June 30, 2005, a difference of $98,000. In other words, Creditors are funding the Working Capital requirements of Ace Mechanical Services.

This is not to say that the company is at risk. Both short and long term risk indicators suggest that Ace Mechanical Service's overall position has been improving.

2003

2004

2005

SHORT TERM RISK

Current Liabilities to Net Worth (%)

402.60%

269.70%

222.88%

LONG TERM RISK

Debt to Equity

5.87

3.35

2.67

Fixed Assets to Net Worth (%)

133.66%

134.00%

160.05%

EFFICIENCY

Inventory Turnover

77.02

68.51

95.99

Assets to Sales (%)

38.03%

38.64%

38.67%

As the company's position has been improving, Current Liabilities are decreasing as a proportion of Net Worth.

The overall Debt to Equity Ratio is also decreasing.

The ratio of Fixed Assets to Net Worth is improving.

The ration of Assets to Sales is remaining constant (whilst Sales are increasing).

There are two underlying causes of poor cash flow.

These are:

Lack of control of the Working Capital Cycle; and

Lack of Profitability

The Working Capital Cycle relates to the speed with which a company turns over the various elements of working capital: cash, debtors, inventory, work-in-progress and creditors. Cash is not the issue here.

Debtors - far too slow (see above)

Inventory - Ace Mechanical Services carries a low level of inventory and turns it over rapidly (96 times in 2005). This is not an issue.

Work-in-progress - Work-in-progress (WIP) is made up of the shop floor hours plus parts and materials that go into a job. Shop floor hours are a Variable Cost (i.e. they will vary with the amount of work undertaken) although Ace Mechanical Services records them against Administrative Expenses and not Cost of Sales. The longer a job takes to go through the workshop (against planned time) the higher will be WIP. Although Ace Mechanical Services does not record this figure, anecdotally we are told that customers sometimes complain about the length of time jobs are taking, suggesting this needs examination.

Creditors - see above.

There is an opportunity for improvement in the control of Debtors and WIP. However these measures, whilst they will relieve the symptoms, will not plug the underlying cash flow leak. WIP is a clue.

The Underlying Problem - Benchmarking Ace Mechanical Services

Further analysis is required to identify the underlying causes of lack of cash in the company.

The Process

Ace Mechanical Service's financial statements as at 30 June, 2005 have been benchmarked against the our Business Benchmarks Library for "Motor Mechanics". This benchmarks companies at various levels:

Against business income - all firms' average, those firms less than $200,000, $200,000 to $324,999, $325,000 to $524,999 and $525,000 or more.

By geography & population - City and suburbs; Non-Metro locations Population > 20,000; Towns with Population up to 20,000 (i.e. where Ace Mechanical Services fits), all businesses with leasehold premises, and firms predominantly in Freehold premises.

Specific key performance measure headings include:

Personal productivity and profit

Margins and major overheads as % of total income

Liquidity

Stock and asset turnover.

The Findings

The benchmarking results show significant opportunities for improvement.

Personal Productivity & Profit

Income per person - an opportunity for improvement. Ace Mechanical Services is well below firms of the same size, high profit firms, and from the similar regions firms.

Gross profit per person - an opportunity for improvement. Ace Mechanical Services is wellbelow firms of their own size, high profit firms and firms from the same region. Note that the Benchmarking excludes wages and salaries for all personnel from their calculation of Cost of Sales. This is a different issue than Income per Person.

Net profit per owner - an opportunity for improvement. Ace Mechanical Services is wellbelow firms of their own size, high profit firms but about the same as firms from the similar regions.

Margins and major overheads as % of total income

Gross profit - Ace Mechanical Services has a higher GP than all benchmark categories which may be due to maximising the return on Parts.

Total overheads - The poorer result more than offsets the higher GP%. Ace Mechanical Services is 18% higher than High Profit firms, 14% higher than firms of the same size and 20% higher than firms from the Same Region (ie. Less than 20,000 people). This may be due to higher staff costs (see Wages, Salaries below) or lower productivity.

Net profits - The impact is seen in substantially lower nett profit - 14% lower than High Profit firms and 4% lower than firms of the same size.

So let's look for some underlying factors:

Rent of premises - Ace Mechanical Services is paying about the same proportion of rent.

Wages, Salaries and Subbies - Ace Mechanical Services is well above other firms in all other categories. The difference accounts for most of the difference in Net Profit figure.

Other depreciation etc - Ace Mechanical Services is higher proportionately but this is a small cost.

Vehicle Operating Costs - Ace Mechanical Services is again higher than the benchmark comparisons but the cost is not large. The difference here and in the figure above account for the balance of the difference in Net Profit between Ace Mechanical Services and the industry.

Liquidity

Some additional information is provided on Liquidity to support the analysis undertaken in the Section above.

Ace Mechanical Services's Average Debtor Days are more than double the industry averages. These range from 23 days to 34 days depending on the category with which Ace Mechanical Services is compared.

Management Decision Making

As stated in the Introduction to this Case Study the business ‘machine' needs systems and procedures just as servicing a vehicle does. All the issues identified above point to a lack of a management ‘system' to underpin the business.

How much time is spent on making decisions about the direction of the business, and to what extent are decisions based on facts and data, as opposed to opinions. One can argue about opinions but it is difficult to argue about facts. Facts are better than dreams.

Lack of systems leads to what management time that is available getting eaten up in dealing with crises and plugging leaks in the business, instead of building a leak proof business.

With an improved systems, time and effort (which should not be underestimated) it should be possible to solve the debtor problem. This will free up cash, make time available and get creditors off your backs. But, and this is a big ‘but', it will not solve the underlying problem of lack of profitability.

The data suggests that the problem lies in the productivity of the shop floor. Either less staff are required to do the available work, or a greater turnover should be achieved with available staff.

Accurate job cards may give some idea where the leaks are, as would measurement of staff utilisation. More formal job scheduling should also assist in improving productivity.

These are all part of the management system.

Do for the business as you would do for equipment!

Growing a business can be difficult. A key step is making the transition from a hands-on trade based business to a business managing its growth.

Why work so hard for so little profit when much more can be achieved for less effort. Service the business machine like you service equipment.

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Some profit losses are pretty obvious - so you fix them.
BUT, what if you don't know profits are leaking, cash out the door?
Possible leaks could be anywhere.
Are there some clues or symptoms that are tell-tales?